9/2/16: Currency Devaluation and Small Countries: Some Warning Shots for Ireland

In recent years, and especially since the start of the ECB QE programmes, euro depreciation vis-a-vis other key currencies, namely the USD, has been a major boost to Ireland, supporting (allegedly) exports growth and improving valuations of our exports. However, exports-led recovery has been rather problematic from the point of view of what has been happening on the ground, in the real economy. In part, this effect is down to the source of exports growth - the MNCs. But in part, it seems, the effect is also down to the very nature of our economy ex-MNCs.

Recent research from the IMF (see: Acevedo Mejia, Sebastian and Cebotari, Aliona and Greenidge, Kevin and Keim, Geoffrey N., External Devaluations: Are Small States Different? (November 2015). IMF Working Paper No. 15/240: http://ssrn.com/abstract=2727185) investigated “whether the macroeconomic effects of external devaluations have systematically different effects in small states, which are typically more open and less diversified than larger peers.”

Notice that this is about ‘external’ devaluations (via the exchange rate channel) as opposed to ‘internal’ devaluations (via real wages and costs channel). Also note, the data set for the study does not cover euro area or Ireland.

The study found “that the effects of devaluation on growth and external balances are not significantly different between small and large states, with both groups equally likely to experience expansionary [in case of devaluation] or contractionary [in case of appreciation] outcomes.” So far, so good.

But there is a kicker: “However, the transmission channels are different: devaluations in small states are more likely to affect demand through expenditure compression, rather than expenditure-switching channels. In particular, consumption tends to fall more sharply in small states due to adverse income effects, thereby reducing import demand.”

Which, per IMF team means that the governments of small open economies experiencing devaluation of their exchange rate (Ireland today) should do several things to minimise the adverse costs spillover from devaluation to households/consumers. These are:

1. “Tight incomes policies after the devaluation ― such as tight monetary and government wage policies―are crucial for containing inflation and preventing the cost-push inflation from taking hold more permanently. …While tight wage policies are certainly important in the public sector as the largest employer in many small states, economy-wide consensus on the need for wage restraint is also desirable.” Let’s see: tight wages policies, including in public sector. Not in GE16 you won’t! So one responsive policy is out.
2. “To avoid expenditure compression exacerbating poverty in the most vulnerable households, small countries should be particularly alert to these adverse effects and be ready to address them through appropriately targeted and efficient social safety nets.” Which means that you don’t quite slash and burn welfare system in times of devaluations. What’s the call on that for Ireland over the last few years? Not that great, in fairness.
3. “With the pick-up in investment providing the strongest boost to growth in expansionary devaluations, structural reforms to remove bottlenecks and stimulate post-devaluation investment are important.” Investment? Why, sure we’d like to have some, but instead we are having continued boom in assets flipping by vultures and tax-shenanigans by MNCs paraded in our national accounts as ‘investment’. 
4. “A favorable external environment is important in supporting growth following devaluations.” Good news, everyone - we’ve found one (so far) thing that Ireland does enjoy, courtesy of our links to the U.S. economy and courtesy of us having a huge base of MNCs ‘exporting’ to the U.S. and elsewhere around the world. Never mind this is all about tax optimisation. Exports are booming. 
5. “The devaluation and supporting policies should be credible enough to stem market perceptions of any further devaluation or policy adjustments.” Why is it important to create strong market perception that further devaluations won’t take place? Because “…expectations of further devaluations or an increase in the sovereign risk premium would push domestic interest rates higher, imposing large costs in terms of investment, output contraction and financial instability.” Of course, we - as in Ireland - have zero control over both quantum of devaluation and its credibility, because devaluation is being driven by the ECB. But do note that, barring ‘sufficient’ devaluation, there will be costs in the form of higher cost of capital and government and real economic debt.It is worth noting that these costs will be spread not only onto Ireland, but across the entire euro area. Should we get ready for that eventuality? Or should we just continue to ignore the expected path of future interest rates, as we have been doing so far? 

I would ask your friendly GE16 candidates for their thoughts on the above… for the laughs…

Economics 07/06/2010: Moving to the next stage in Euro crisis

Last Friday, speaking at the CPA annual conference (will be posting the highlights of the speech here later) I referred to a new 'beast' of the sickly-prickly Eurostates: the BAN-PIIGS. The new bit - 'BAN' - referred to Belgium, Austria and the Netherlands.

Fast forward two days, getting off the trans-Atlantic flight in hot and humid New York guess what hits my news feed? Belgium and France taking in water on the back of Hungary's woes (see earlier post here) and Ukraine is putting some new pressures on Euro area banks. French and Belgian CDS are moving up, while Austria is also back in the spotlight.

Brian Lenihan's announcement that Irish banks will be rolling over €74.2bn of guaranteed loans, bonds, and other systemic support papers before October 1 guarantee is scheduled to run out is not helping the markets either. As Morgan Kelly, Karl Whelan and couple other analysts estimated - once again well ahead of our gallant DofF 'forecasters' - everyone dependent on the Irish government guarantees will be pushing their re-scheduling/roll-overs before October hits.

Surprised? You see - we used to have one main crisis back in 2008-2009: insolvency of banks balancesheets. It should have been resolved directly through recapitalization of the banks via equity take overs by the taxpayers and restructuring of the banks debts. Foolishly, we chose a different path:

• We facilitated banks rolling over debt - as if changing maturity date on the bonds that cannot be serviced changes the level of debt impacting the banks;
• We then proceeded to allow banks to name their capital requirements by allowing them to spread their losses over longer time horizon, as if changing the date of repayments start on a defaulting loan can make the loan perform;
• Following this, we pumped the banks with steroids of ECB facilitated lending - as if swapping few private bonds for ECB loans resolves the problem of balance sheet overhang;
• We created Nama to take bad loans off the banks balancesheets, but, realising the futility of the undertaking, went on to impose unrealistically low haircuts that simply sped up some of the very process of losses recognition in the second bullet point above. Given the levels of real impairments on the loans, Nama only bought banks more time to spread their losses, thus avoiding recognizing the problem of weak balance sheets and amplifying the problem of insolvency;
• Amidst all of this, banks became liquidity traps - sucking up vast amounts of funding. This was not fully satisfied by the ECB, so the banks engaged in predatory re-pricing of performing loans (mortgages etc) in a futile effort to get some more cash flowing;
• The insolvency crisis blew up into a liquidity crisis.
  

So now we have both. And no real way of resolving either or both.

We could have sustained this game, teetering on the brink between full insolvency and a credit crunch, if and only if the euro bonds markets were at the very least stable and the ECB was capable of parking collateral garbage it collected in exchange for banks loans for a long time. Alas, two things are currently under way.

First, the French bonds have slid off their 'safe heaven' pedestal over the last couple of weeks, with spreads over the German bund going up eight-fold since the end of 2009. French bonds are now posing massive liquidity risk to institutionals holding them. French Prime Minister declared last week that: “I only see good news in parity between euro and dollar”. In effect, the French are now openly inviting massive devaluation of the euro - something that is bound to disappoint Germany.

Second, there is no room for more Quantitative Easing, as the ECB has been exposed as an institution that has run out of reserves cover for its own operations. Last week, ECB balancesheet had more than 150% ratio of immediate liabilities to assets held. And that was only for liabilities vis-a-vis Greek rescue package.

Something will have to give, folks. Just as Ireland has precipitated its own implosion by pushing the liquidity crisis on top of our already formidable insolvency crisis, so the ECB and the entire euro zone is now working hard to achieve the same. We are now well behind that point of no return in monetary policy where promises to act with support for the sovereign bonds will be sufficient to stave off a run on the bond yields. Instead, the ECB's rhetoric will be tested, leaving it only one option - start running printing presses.

Now, those of you who followed my writings on the issue will say 'Good, we need a massive - €3-5 trillion - issuance of cash, don't we?' The problem is that while the answer is 'yes, we do', this emission cannot simply involve purchasing of more Government bonds. We need a direct, un-levered injection of new money into the system and it must be broadly based - going not just to the public coffers, but to private economies of the Euro area as well. ECB printing cash to buy Government debt will not reduce the debt levels for the Eurozone sovereigns (which means insolvency problem will remain and will actually increase), nor will it resolve the problem of liquidity crunch in the block (giving money to the Governments to finance roll over of existent debt is about as liquidity-enhancing as burning this cash in a fireplace).

The end game, in my view, can be only across three major disruptions in the euro assets:

• Collapse of the euro below parity of the US dollar; followed by
• Debt restructuring through offers to the bondholders to take a haircut (possible ranges: 35-50% for Greece and Portugal, 25-30% for Spain, 20% for Ireland and Italy, 15-20% for Austria, Belgium... and so on). These will be attempted first privately - via larger institutional consortia, with both sticks (threat of default) and carrots (some sort of delayed tax incentives?) being deployed to get larger institutional holders to accepts a drastic shave off; and once this is underway, the inevitable conclusion to the crisis will be:
• Imposing haircuts on banks bondholders, with the ECB standing by to hose the banks with cash, should liquidity dry up during the haircut imposition.
  

Finale: euro's credibility gone, euro/usd rate below parity persists, inflation will be running ahead of economic recovery and Europe will slide into a Japan-styled long-term depression.

In the mean time, before the end game, expect more bans on trading in various instruments (the French have finally agreed to the German-style ban on naked shorts) and more fiery rhetoric about speculators, destabilizing market forces and other gibberish from the dear leaders of Europe.


PS: All of this reminds me of a conversation I had with one very senior stocks analyst/strategist back in the middle of 2008 meltdown in the markets. I was concerned that the ways in which fiscal and monetary authorities were throwing cash at the banks were going to lead to both running out of policy space to continue accelerated supports for the sector and economy at large. "Charged by the bear, make sure you don't run out of all bullets early on. You might miss," I insisted. In response I was given a complete assurance that resolute actions on large scale (equivalent to unloading the entire magazine of ammunition at the shadow of the problem before actually having an idea as to what the problem really is) will mean that the 'Bear won't be charging for long'. I wish I was wrong... He still writes daily, weekly and monthly missives about the investment strategy for clients.